Regulators focus on S&P 500 futures in ‘flash crash’ probe

A preliminary report by the US Securities and Exchange Commission and the Commodity Futures Trading Commission into the ‘flash crash’ market turmoil of May 6 has narrowed the possible causes to six “working hypotheses” – including the influence of E-Mini S&P 500 Index Futures trading at CME Group.

The first idea in the report, issued on May 18, is a possible
link between the "precipitous decline" in the prices of stock
index products – in particular the E-Mini S&P
Index 500 Futures and index-tracking exchange-traded funds
– and simultaneous and subsequent waves of selling of
individual securities. The regulators said activity in one
market may have led the others.

On the afternoon of May 6 in the US, the Dow Jones Industrial
Average dropped nearly 1,000 points in minutes before
recovering its losses.

The agencies’ investigation is focusing on events
between 2pm and 3pm. Some 250 firms executed transactions in
E-Mini S&P 500 Index Futures in that time, and the
regulators are particularly looking at the 10 largest holders
of both long and short positions.

The report highlighted one firm, which the SEC and CFTC said
executed only sell orders between 2.32pm and 2.51pm. It held
positions estimated by the regulators to be worth about 9% of
transactions in the futures contract in the hour under
investigation.

However, the CFTC and SEC said they were satisfied the firm was
only engaging in a hedging strategy.

Waddell’s defence

The name of the firm has been the subject of much rumour. On
May 15 Reuters named Kansas-based mutual fund manager Waddell
& Reed as the mystery market participant. A spokesperson
for Waddell declined to confirm or deny this, but the firm
issued a statement confirming that it was one of the 250 active
market participants.

The firm said: "On May 6, when the portfolio managers reached
the conclusion that the risk of the European sovereign crisis
extending to the United States and our financial system was
increasing, they decided to reduce the funds’
equity exposure quickly. They used the E-Mini S&P 500 Index
Futures contract as part of their equity hedging strategy. The
E-Mini is highly liquid and widely traded. They sold E-Mini
contracts to reduce equity exposure, and their trading was just
1% of overall trading volume on May 6 (75,000 of the 5.7m
contracts traded that day). We believe we were one of 250 firms
engaging in E-Mini trading during the period of the market
selloff. Further, we believe that trades of the size we
initiated normally are absorbed easily in the market."

Waddell & Reed added: "While we executed a number of
trades, the volume was not large relative to the overall depth
of the market. We believe that the behaviour both of the price
of the E-Mini and the bid/ask spread on the E-Mini also do not
suggest that our trades had a disruptive effect. The E-Mini
rallied during our trade, suggesting it was not causing the
price movement. And the bid/ask spread widened during our trade
for less than one second only."

Implying no judgement on any market participant, the SEC and
CFTC said that while trading in the S&P 500 Futures
contract was high, there were "many more" sell orders than buy
orders between 2.30pm and 2.45pm. However, during this 15
minute period, many active participants withdrew from the
market. "Considerable selling pressure at this vulnerable
period in time may have contributed to declining prices in the
E-Mini S&P 500," the report said. This slump in price might
have influenced selling of other instruments.

Liquidity problems

The SEC and CFTC also said the 5% fall in the price of the
S&P 500 Future may have been a consequence of the market
turmoil rather than a trigger.

They highlighted a "severe mismatch in liquidity", as evinced
by sharply lower trading prices and possibly exacerbated by the
withdrawal of liquidity by electronic market makers and the use
of market orders, including automated stop-loss orders.

The regulators said the liquidity mismatch may have been
exacerbated by disparate trading conventions among various
exchanges, whereby trading was slowed in one venue, while
continuing as normal in another.

The CFTC and SEC suggested so-called "stub quotes" may also
have influenced the market upheavals. They said stub quotes are
designed to technically satisfy a requirement to offer a "two
sided quote" but are at such low or high prices that they are
not intended to be executed.

The fifth possible cause was the use of market orders. Stop
loss market orders and stop loss limit orders might have
contributed to market instability and a temporary breakdown in
orderly trading, the two US watchdogs said.

Finally, they pointed to exchange-traded funds, the asset class
affected most by the price falls of May 6. The report offered
four explanations for their influence.

First, an inability by ETF market participants to hedge
positions during periods of severe volatility may have
contributed to a lack of liquidity in underlying shares.

Second, because ETFs are used by institutional investors as a
way to quickly acquire (or eliminate) broad market exposures,
this investment strategy may have led to substantial selling
pressure on ETFs as the market began to fall steeply.

Third, as in the equity markets, the impact of ETF stop loss
market orders, particularly from retail investors, may have
triggered declines.

Finally, a severe drain on liquidity at NYSE Arca –
the primary listing exchange for most ETFs, may have had a
greater impact on market liquidity and trading for ETFs than
for the underlying shares.